Report to the Treasury Committee

Mark Carney, Governor of the Bank of England

15 February 2019

Economy and voting record

Context

At the time of my previous report, the global economy was growing at its fastest pace in
several years. More than three-quarters of the world was growing at above-trend rates (see
Chart 1), and the global expansion was increasingly driven by investment and trade. Global
financial conditions were highly accommodative.

This strong global environment was supporting UK activity. UK growth had picked up
slightly, from its slow pace earlier in 2017, with net trade benefiting from strong external
demand and the past depreciation of sterling. British exporters were in a sweet spot, with
sterling down around 16% overall (and around 20% against the euro) relative to its November
2015 peak in anticipation of a Brexit that had not yet happened.

Domestic demand growth was relatively modest, despite accommodative financial

CPI inflation was around 3.0%. The overshoot of the MPC’s 2% target was entirely due to
the effects of higher import prices as a result of sterling’s depreciation. I expected inflation
to fall back gradually to target over the next few years, as external factors gradually
diminished and domestic inflationary pressures firmed with the economy moving from excess
supply into excess demand.

Against this backdrop, I judged (along with the rest of the MPC) that it would likely be
appropriate to reduce the degree of accommodation at a limited pace and to a gradual extent
in order to return inflation sustainably to target.

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In the following months, it became clear that the economy had slowed sharply in the first
quarter with GDP growth of 0.1%, its weakest pace in six years. Inflation also came in
notably lower than expected.

By the time of its May meeting, the MPC faced the key question whether that softness in
activity would prove temporary or persistent; in other words, was the weakness in the first
quarter due to disruptive weather or a new weaker economic climate?

At the time, I judged that the weakening in activity largely reflected the weather, and that the
underlying pace of growth was more resilient than the headline data suggested. I joined the
majority of the MPC in judging that it was appropriate to maintain the accommodative stance
of monetary policy in May recognising the value in seeing how the data unfolded over the
coming months. The costs to waiting for additional information appeared modest, given the
need for only limited tightening over the forecast period to return inflation sustainably to the
target. I explained this approach in a speech to the Society of Professional Economists on 24
May 2018. I believe that ensuing events were consistent with that judgement.

By August, incoming data was consistent with the view that the dip in activity in the first
quarter was temporary. A number of indicators of household spending and sentiment had
bounced back strongly, employment growth had remained solid, and surveys of business
activity had been stable. The labour market had also continued to tighten. Unemployment
was at a 42 year low, the employment rate and number of vacancies were at record highs, and
job-to-job flows were around pre-crisis levels. Indicators of pay growth had continued to
strengthen (see Chart 2), broadly as expected. Private sector wage growth has increased to a
little under 3%, up from 2½% in 2017 and 1½% over 2010-14.

With evidence of domestically generated inflation building and the prospect of excess
demand emerging, in August I judged that a modest tightening of monetary policy would be
appropriate to return inflation to the 2% target sustainably, and voted along with the rest of
the MPC to raise Bank Rate by ¼ percentage points from ½% to ¾%. This increase in Bank
Rate was another step on the path of the gradual removal of policy stimulus which had begun
in November 2017.

Since August, a series of transitions both at home and abroad have affected the outlook for
the UK economy and the stance of monetary policy.

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At home, business investment weakened further in second half of 2018 and evidence
suggested this primarily reflected Brexit-related uncertainty. On the most recent data,
business investment fell 3.7% over the past year and its level is now lower than prior to the
referendum (see Chart 3). The Bank’s Decision Maker Panel of over 7000 firms suggested
that Brexit’s importance as a source of uncertainty has risen, and the Bank’s Agent surveys of
investment intentions cites Brexit as the largest headwind to capital spending.

Global momentum weakened over the autumn in all major regions and downside risks
intensified. By late 2018, the proportion of the global economy growing above trend had
fallen to one-third (see Chart 1). As a result, financial markets now expect more
accommodative monetary policies in all major economic areas.

The deceleration of the global economy reflects the shift from accommodative to tighter
financial conditions over 2018, rising trade tensions, and growing policy uncertainty. The
impact of growing protectionism on the global economy is an issue I had spoken about earlier
in the year at the Northern Powerhouse Business Summit in July, and again in February of
this year at Frobisher Hall.

UK growth slowed sharply in late 2018 and appears to have remained weak in early 2019.
This slowdown reflects softer activity abroad and greater effects from Brexit uncertainties at
home.

The current outlook is clouded by uncertainty around the UK’s economic relationship with
the EU. This uncertainty is creating a series of tensions for business, households and in
financial markets that will cause short-term volatility in the economic data, which I expect to
provide less of a signal about the medium-term outlook.

Judging the appropriate stance of monetary policy requires focusing on the more persistent
factors affecting inflation. The fundamentals of the UK economy are sound. The financial
sector is resilient. Corporate balance sheets are strong. And the labour market is tight.

In the February 2019 Inflation Report, I voted to keep Bank Rate unchanged and noted that if
conditions evolve in line with our projections, which are conditioned on the assumption of a
smooth transition to the average of a range of possible outcomes, limited and gradual rate
rises are likely to be needed to return inflation sustainably to target.

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Providing Guidance on the MPC’s Reaction Function

The MPC’s conduct of policy over the course of the past year has provided important
perspective on how it can be expected to react to evolving economic conditions.

The objective of forward guidance is to give insights into the MPC’s reaction function – in
other words, how the Committee will adjust policy when the outlook for growth and inflation
changes.

In a perfect world, guidance would be redundant. People would know how the MPC intends
to set rates over the future and how those intentions would adjust to economic developments
in all eventualities. But the world is complex and people do not have endless time to devote
to understanding monetary policy. In practice, therefore, guidance can be useful in providing
people with information about how the MPC sets policy and, over time, in improving
understanding of how monetary policy will adjust to news.

Guidance helps people to think along with the Committee so that their expectations about the
path of policy adapt with ours as economic circumstances change. This can make monetary
policy more effective by reducing unwarranted volatility in interest rate expectations, and as a
consequence, the extent to which the MPC has to move Bank Rate to meet the inflation
target.

Guidance is not a promise of the future path of policy. And its use will not mean that all
observers will agree on the likely path of policy for the simple reason that not everyone will
agree on the likely path for the economy. However, with guidance, someone who has a
different outlook can better anticipate how the MPC will adjust once the scales fall from the
Committee’s eyes.

Over the past year, the MPC has provided three forms of guidance.

First, the MPC has consistently stressed that any future increases in Bank Rate were likely to
be at a gradual pace and to a limited extent. As a result, interest rate expectations of
households and businesses have remained in line with this guidance (see Chart 4). This
guidance has anchored expectations in financial markets that interest rates will rise at a
gradual pace and to a limited extent (see Chart 5), and dampened the volatility of interest
rates, consistent with the expected and actual path of policy rates. This guidance has reduced
the impact of economic uncertainty on short-term interest rates (Chart 6).

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Second, the MPC provided important, updated guidance on its asset purchases in June of last
year. Previously, the Committee had noted that it would not begin reducing the stock of
assets until Bank Rate had reached around 2%. That reflected the MPC’s preference to use
Bank Rate as the primary instrument for monetary policy and its desire to have sufficient
scope to cut Bank Rate materially, if necessary to respond to adverse shocks.

Although the principles guiding the MPC’s choice of threshold still hold, the creation of the
Term Funding Scheme had reduced the effective lower bound on Bank Rate from ½% to 0%.
The MPC now views that the level from which Bank Rate can be cut materially is now
around 1½%. Reflecting this, the MPC now intends not to reduce the stock of purchased
assets at least until Bank Rate reaches around 1½%.

Third, the MPC set out its monetary policy strategy to Brexit in a box in the November 2018
Inflation Report. That strategy recognises that Brexit is a regime shift that has markedly
increased the range of possible outcomes for the UK economy and therefore the potential
paths of monetary policy. The predictability of monetary policy can break down when there
are large structural changes in the economy’s supply capacity, equilibrium interest rates or
trading relationships. In such circumstances, forward guidance can help anchor expectations
and improve the effectiveness of monetary policy.

The Committee has stressed that the appropriate response of monetary policy to any
particular Brexit scenario will depend on the balance of the effects on demand, supply and the
exchange rate.

The MPC discussed and commented on a range of Brexit scenarios produced by Bank Staff,
including one consistent with the Political Declaration setting out the framework for the
future relationship between the European Union and the United Kingdom and one consistent
with a transition to default World Trade Organisation (WTO) rules. These scenarios were
submitted in a report to the Treasury Committee on the 28 November, following a request by
the Treasury Committee.

In the case of a smooth transition to a relatively close economic relationship with the EU, the
extent to which domestic inflationary pressures increase would depend on the balance
between an expected rebound in demand as uncertainty fades, any further impacts on supply
over the MPC’s policy horizon as investment rebounds and some capacity is retrieved, and
the likely appreciation of sterling.

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In contrast, a disruptive withdrawal from the EU would probably result in a further decline in
the exchange rate and a large, immediate reduction in supply. Tariffs might also be extended.
Each of these developments would tend to increase inflation. Set against that, it is likely that
demand too would weaken, reflecting lost trade access, heightened uncertainty and tighter
financial conditions. The overall extent of inflationary pressures would depend on the balance
of these forces, as well as the evolution of inflation expectations.

Although the nature of EU withdrawal is still uncertain at present, and its impact on the
balance of demand, supply and the exchange rate cannot be determined in advance, under all
circumstances, the MPC will respond to any material change in the outlook to bring inflation
sustainably back to the 2% target while supporting jobs and activity. The MPC have made
clear that the response of monetary policy to Brexit is not automatic and could be in either
direction.

As my colleague Gertjan Vlieghe has noted, that does not necessarily mean that, in the event
of a no deal no transition scenario, either direction of policy is equally likely. Given the
exceptional circumstance associated with Brexit, I would expect the Committee to provide
whatever monetary support it can consistent with the price stability remit given to the
Committee by Parliament. But there are clearly limits to its ability to do so. Moreover there
are possible no deal, no transition Brexit scenarios, particularly those in which there is a
material hit to the supply capacity of the economy and inflation expectations threaten to
become less well anchored, where the MPC’s tolerance for a sustained overshoot of the
inflation target could be breached and some tightening of monetary policy would therefore be
required to bring inflation back sustainably to target consistent with the MPC’s statutory
duties.

Explaining monetary policy

To ensure that our policies are effective, the Bank needs to be understood, credible and
trusted. We do this by being transparent about what we do and why we take policy decisions
so that people can hold us to account. This means communicating with members of the
public, businesses, and market participants.

Traditional outreach activities

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I have continued to explain monetary policy and my voting record through existing
approaches, including speeches, press conference and committee appearances, meetings with
a wide range of businesses, and regional outreach visits.

Over the past year, I have participated in 102 speaking engagements about the Bank’s work,
including six on-the-record speeches covering aspects of monetary policy and given four
Inflation Report press conferences (and two press conferences on the Financial Stability
Report). I have given evidence to the Treasury Committee on monetary policy four times,
and once on the Bank’s report on the UK’s withdrawal from the EU at the Committee’s
request.

I have made five visits around the United Kingdom to hear from business leaders from a
range of sectors on their perspectives on the economic outlook. These included on-site
company visits, roundtable events with local business people, and third-sector stakeholders
including the voluntary sector, unions and schools.

Since February 2018, I have attended a number of international meetings to explain the
monetary policy position in the UK. This includes speaking at the G7, G20, IMF, FSB (as
Chair), ESRB (as First Vice-Chair), BIS (as Chair of the Global Economy Meeting and the
Economic Consultative Committee) and the World Economic Forum. I have also participated
in roundtable events in Argentina, China, the US and the EU to allow more in-depth
engagement with stakeholders. I have held bilateral meetings with numerous central bank
governors and finance ministers over the course of the year to gather perspectives on the
global economy.

I have also reiterated the Bank’s public messages and heard the perspectives of a range of
professional associations and business groups, including the British Retail Consortium,
Confederation of British Industry and the Productivity Leadership Group, as well as having a
wide range of ad hoc meetings with industry groups to discuss how developments are shaping
the economic outlook.

I have also corresponded with many members of the public, MPs and their constituents in
response to letters that they have sent me about the MPC and monetary policy. In 2018, the
Bank received and responded to around 340 letters to the Bank about monetary policy from
members of the public. I have given 24 national and regional television, radio and print
interviews since February 2018.

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New outreach initiatives

Explaining monetary policy to a broader audience is central to the Bank’s new strategy. We
have revamped our publications to make them more accessible, and now produce more
creative content targeted at different audiences that can be more readily shared on social
media. Building on the introduction of Inflation Report visual summaries in November 2017,
we launched Bank Overground in January 2019. This new digital platform – which
compliments Bank Underground - publishes bite-size posts that summarise a piece of staff
analysis, which supported a policy or operational decision in order to provide more visibility
on the evidence that informs our decisions.

We have also broadened our public outreach and educational initiatives. We have been
building new partnerships with other educational organisations to extend our impact and
reach, and developed more teaching materials for schools, such as econoME. econoME is a
free education resource aimed at young people, designed to be accessible for students and
teachers alike, which launched in April 2018. The material is designed to help young people
understand the economy better and provide them with the analytical skills to make informed
decisions. To date, over 1,300 individual schools have registered for the resources,
representing almost 30% of total secondary schools in the UK in 2017/18.

The 2018 Future Forum ‘Let’s Decide the Future of Money’ was the first held digitally,
running on a virtual platform, to involve as many people as possible across the whole of the
UK. As part of this Forum, I hosted the culmination event - a roundtable discussion - with
my fellow Deputy Governors, 6 industry contacts and 20 of the most engaged platform users.

The Bank also piloted its first set of Citizens’ Panels in 2018. The aim of these panels is to
establish, in a structured, systematic and comprehensive way, a two-way dialogue and
collaboration between the Bank and a panel of citizens on the economy, financial system and
policy. The inaugural panels were held in Northern Ireland and North East England in 2018
Q4, and feedback from both events was extremely positive. We are aiming to run 24 panels,
2 in each region, over 2019/20, and expect them to become a permanent feature of our
outreach efforts.

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 Annex
Chart 1: The global outlook has weakened with fewer Chart 2: UK wage pressures are building as slack is
countries growing above potential absorbed
Share of PPP-weighted global GDP, per cent 100 3.5 Four-quarter wage growth (per cent)
3.0 Darkest values are 2018
80
2.5
60 Lightest values are 2013
2.0
40 1.5

20 1.0

0 0.5
2013 2014 2015 2016 2017 2018 2018 Unemployment rate (per cent)
0.0
H1 Q3 3.0 4.0 5.0 6.0 7.0 8.0
Sources: Datastream from Refinitiv, IMF WEO, OECD and Bank calculations.
Sources: ONS and Bank calculations.
Note: Averages of annualised quarterly growth in real purchasing power parity
(PPP)-weighted GDP. Note: The wage measure is Average Weekly Earnings (AWE) regular pay.

Chart 3: The recovery in UK business investment has Chart 4: Households and businesses have consistently
stalled since the EU referendum expected increases in interest rates to be
Indices: peak in GDP = 100
gradual and limited
180
Median household Bank Rate Per cent
expectations 6
Average 160
5
Pre-crisis average level of
140 2014 Q1 2015 Q1 Bank Rate (5.2%) 4
Range of previous 2016 Q1 2017 Q1
120 3
recessions
2018 Q1
2
100
EU 1
Referendum
80 0
2008 Act
0 1 2 3 4 5 6
60 Years ahead
0 5 10 15 20 25 30 35 40 Sources: Bloomberg Finance L.P., ICE, and Bank calculations.
Quarters since pre-recession peak in GDP
Notes: Household expectations are from the Bank/TNS Inflation Attitudes
Sources: ONS and Bank calculations. survey and show how Bank Rate is expected to increase relative to the rate
prevailing at the time. Pre-crisis average Bank Rate is calculated from 1997 to
2007 inclusive.

Chart 5:Guidance has anchored expectations in financial Chart 6: Guidance has reduced the correlation between
markets that interest rates will rise at a gradual pace and economic uncertainty and interest rate volatility
to a limited extent
Historic UK Bank Rate tightening cycles

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 2.0 Economic uncertainty and option- 3m rate
Cumulative change, percentage points implied volatility of 3 month rates 1 standard
1.8
September 1994 year ahead deviation
November 1.5 August 2013 - 1.6
2003 October 1996 EU referendum 1.4
September
1999 1.0 1.2
August 2006
1
November 2017 2000-August 2013 0.8
0.5
February 2019 Inflation Report 0.6
market interest rate path EU referendum - latest 0.4
0.0
0.2
Months since first increase in Bank Rate 0
Sources: Bank of England, Bloomberg Finance L.P. and Bank calculations.
-2 -1 0 1 2 3 4 5
Economic uncertainty (deviations from average)
Notes: Tightening cycles since the start of inflation targeting in 1992. Tightening Sources: Bloomberg Finance L.P., ICE, and Bank calculations.
cycles are shown up to when interest rates reached their highest level before they
were next reduced. The curve is estimated using instantaneous forward overnight Note: The indicator of economic uncertainty is based on the principal
index swap rates. component from seven measures: FTSE and sterling option-implied volatility,
dispersion of company earnings forecasts and among forecasters’ growth
projections, proportion of companies reporting that uncertainty is limiting
investment, households’ unemployment expectations, and number of press
articles citing ‘economic uncertainty’.

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